Topic 7 - Managing Liabilities Flashcards
DEFINITION OF LIQUIDITY
Liquidity refers to the ability of an ADI to access funds to make payments as and when they fall due
The two main types of payments that have to be made by an ADI are
withdrawals by depositors and drawdowns of loans by borrowers
The main sources of liquidity for an ADI are
exchange settlement accounts, holdings of other liquid assets and access to borrowed funds
LIQUIDITY RISK
Liquidity risk is the risk that the ADI will be unable to access sufficient funds to make a payment It arises from the difficulty in predicting payment requirements
To protect itself against a shortfall, an ADI will
hold surplus liquid assets
The level of an ADI’s liquidity risk is determined by
the size of this buffer relative to the unpredictability of its payment requirements
A liquidity shortage can be costly:
The ADI may be forced to reduce its level of new lending, and hence it may miss out on profitable business
It may be unable to honour a withdrawal request, endangering the ADI’s reputation and risking the possibility of a “bank run”
It may have to pay additional costs to access extra liquidity, such as selling long-term assets at a loss or having to borrow at short notice and high cost
From the mid-1980s until 1999, the two main liquidity requirements imposed on banks were:
Prime Asset Ratio (PAR) requirements
Non-callable deposits (NCDs)
Prime Asset Ratio (PAR) requirements
these required banks to keep a certain percentage of total liabilities as “prime” or liquid assets, such as cash and government securities
Non-callable deposits (NCDs
banks were required to keep 1% of their total liabilities on deposit with the reserve bank (which were paid 5% less than the market interest rate)
An ADI’s liquidity management policy will include a range of strategies, including:
Setting limits an maturity mismatches
Holding sufficient liquid assets to meet anticipated liquidity needs
Diversifying liability sources so that the ADI is not unduly affected by changing economic circumstances Developing asset sales strategies, should this be required
The two main components in the process of ensuring the provision of adequate liquidity involve:
Exchange settlement accounts (ESAs) which are designed to meet the current day’s payments Estimating future liquidity requirements and ensuring that the ADI will have access to sufficient funds as and when required
DEFINITION OF ESAs
Exchange settlement accounts (ESAs) are accounts held by banks with the RBA, and are used to settle interbank payments on a daily basis
Payments can be settled in two ways
deferred net settlementand real time gross settlement
DEFERRED NET SETTLEMENT (DNS)
DNS is used to settle cheque payments and small-value, high-volume payments such as EFTPOS and bulk electronic payments
These transactions are aggregated each night by a clearing house
The next day the clearing house advises the RBA of the net amounts owed to or by each bank, and ESAs are credited and debited accordingly
REAL TIME GROSS SETTLEMENT (RTGS)
RTGS is used to settle high-value, time-critical payments
The gross amount of each payment is debited and credited to the respective banks’ ESAs, as soon as they are entered into the system
This puts greater strain on bank liquidity because there must be sufficient funds in the ESA to cover the gross amount of each payment
An ADI’s liquidity needs will vary over time. Some of the issues that must be taken into account when estimating future liquidity needs include:
- Short-term or seasonal factors
- Cyclical liquidity needs
- Trend liquidity needs
- Contingency liquidity needs
SHORT-TERM OR SEASONAL FACTORS
Short-term factors might include unique meteorological, economic or political events that impact upon the level of deposits and borrowing
Seasonal factors are likely to affect monthly liquidity needs in a recurring pattern from year to year
CYCLICAL LIQUIDITY NEEDS
Liquidity needs can vary cyclically, in response to economic conditions, interest rates and other factor
Recessions are typically periods of high liquidity, with growing deposits but flat demand for new loans
Boom periods typically result in greater liquidity needs, with declining deposits and high demand for loans
TREND LIQUIDITY NEEDS
liquidity requirements due to fundamental changes in the community in which an ADI operates
For example, rapidly expanding communities are likely to generate increasing demand for new loans, whereas stable communities are likely to generate increasing deposits with flat demand for loans
CONTINGENCY LIQUIDITY NEEDS
an ADI needs to plan for unexpected variations in liquidity
These could be caused by new demand for funds, or the closure of a source of liquidity, due to an unanticipated event Liquidity management policies (approved by APRA) must include planning for such contingencies
Stored liquidity
Stored liquidityrefers to assets –generally, liquid assets which held on the balance as a source of liquidity
Stored liquidity assets can be defined as:
Assets in which funds are invested that will mature before the funds are required, or
Assets that are readily saleable, without material loss, before they mature
The main examples of stored liquidity are:
Cash –Notes and coins available to meet payments
Treasury notes and Commonwealth government securities –These can be sold into the market or can be used to access funds from the RBA with repurchase agreements
Loans to short-term money market dealers
–e.g.: “11am cash” –an overnight loan that must be repaid by 11.00am or reinvested for another day “24-hour cash” –a short term loan requiring 24 hours’ notice for repayment
Bank accepted bills
Certificates of deposit
Commercial paper (promissory notes)
Semi-government securities
Other securities (e.g. corporate bonds and equities)
Purchased liquidity
refers to borrowing funds as needed to meet liquidity needs
Purchased liquidity examples
Exchange settlement accounts –banks with surplus funds in their accounts are usually prepared to lend to those with a potential deficit
Interbank market –banks will often borrow from each other or from other financial institutions
Repurchase agreements –typically using government or semi-government securities as security for what is effectively a short-term loan
Large certificates of deposit –CDs in excess of $100,000 can be issued to corporations with surplus cash
Euro$Adeposits –Deposits raised outside Australia denominated in Australia dollars
Other types of liabilities, such as long-term corporate bond
Defineliquidassets.
Liquidassetsareassetswhichcanbesoldquicklyatafairmarketprice:thatis,without lossofvalue
DefineliquidityriskasitaffectsanADI
ADIliquidityreferstoanADI’saccesstoliquidfundswithwhichitcaneffectpaymentsas they become due. These payments include paying depositors who wish to make withdrawalsandpayingoutonloanstoborrowercustomers.
LiquidityriskistheriskthatanADIwillhaveinsufficientfundsavailableaspayments becomedue.IfanADIhasdifficultymakingthesepaymentsitmaylimitnewlending thereby foregoing profitable business or it may acquire additional liquidity but at apenaltycost.If,infact,theADIcannotmakethepromisedpaymentthiswillthreaten confidenceintheADIandmayleadtoanADIrun.
OutlinethreewaysinwhichanADImay respondtoaprojectedshortageof liquidity.Explainwhyeachofthese threeresponseswillhaveanadverse effectonbank profitability
IfanADIhasaprojectedshortageofliquidityitmay:
(I)limitnewlending,butthismeansnotmaking
profitablenewloanstherebyreducing profitability.
(ii) Acquireadditionalliquiditybysellingnon‐liquidassetsatalossorbyborrowing funds
atanabovemarketinterestrate,
inbothcasesthebank’scostswouldriseand
itsprofitabilitywouldfall.
(iii)Refusewithdrawalrequestsandrefuse
toallowcustomerstodrawdownapproved loans.Thisislikelytotriggerpanicamongdepositors
andarunonthebank.This wouldfurther
escalatetheliquidityshortage
andthreatentheviabilityofthebank, inwhichcasethebankwouldnotbeableto
carryoutitsnormalbusinessagain therebythreateningprofitability.
Briefly explain the approach taken to liquidity management by APRA in its role as prudentialsupervisorofADIs.
APRArequiresallbankstohaveinplaceanapproved
liquiditymanagementpolicy.Thispolicy mustcaterformanagementofday‐to‐dayliquidityanditmustincludeapolicyforresponding toacrisissuchasabankrun.
Why might ADI management impose limits on maturities as part of its liquidity managementprocess?
Ifmaturitiesofassetsmatchmaturitiesofliabilitiesthen
fundsreceivedfrommaturingassets shouldmatchfundspayableonmaturingliabilities
therebyminimisingliquidityrisk.
Outlinethemainfeaturesofexchangesettlementaccounts.
Exchangesettlementaccountsareheldbybanksand
specialserviceproviderswiththeReserve BankofAustralia.Theyearninterestatarateequalto
theRBAtargetcashrateminus0.25%, andtheyarenotpermittedtobeoverdrawn.
Theseaccountsareusedtosettlepayments betweenADIs.
Distinguishbetweenstoredliquidityandpurchasedliquidity.
Assetliquidity(orstoredliquidity)referstoholdingsof
liquidassetswhichcanbesoldif thebankneedscash.Liabilityliquidity(orpurchased
liquidity)referstoabank’sabilityto borrowfundstoprovideitselfwiththerequiredcash.
Distinguishbetweenseasonalandcyclicalliquidityneeds.
Seasonalliquidityneedsreflectregularfluctuations
whichoccuratthesametimeandin thesame
directioneachyear.Forexample,when
taxpaymentsareduetherewilltypically beanincreaseinwithdrawals.Incontrastwhen
taxrefundsarereceived,thereisan increasein
deposits.Thesefluctuationscan
generallybepredictedfrompastexperience andthebankcanmanageitsliquiditypositions
accordingly. Cyclicalliquidityneedsrelatetothe
economiccycle.Forexample,abankislikelyto experienceanincreaseinloandemandduring
theexpansionaryphaseoftheeconomic cycle.Theresultingliquidityneedsaredifficult
topredict,someguidancemaybetaken from(a)theproportionoflinesofcreditcurrently
drawndown—cyclicalneedsmaybe predictedasbeingequaltothedifferencebetween
thecurrentdrawdownrateandthe maximumrateexperiencedinthepast(say10years),
(b)correlationsbetweendeposit flows and other
indicators such as interest rates, cyclical liquidity
needs should beconsideredinlightoftheleveloffunding
diversificationandreliabilityofdifferentfunding sources,(c)statisticaltimeseriesanalysis.
Whyareforecastsofseasonalliquidityneedsgenerallybelievedtobemorereliable thanforecastsofcyclicalliquidityneeds?
Forecastsofseasonalliquidityneedsaregenerally
believedtobemorereliablebecause seasonalfluctuationscanbeestimatedonthebasisofpastexperienceandarelinkedto specificregulareventssuchastheduedatefortax
paymentsandtheregularperiodsfor primary producers’
expenses and income receipts. ADIs can alsoimprovetheseprojectionsbydrawingon
informationabouttheneeds
andintentionsoftheirlarge customers. Ontheotherhand,cyclicalliquidityneedsarelargely
relatedtobroadmovementsintheeconomy.
Thesearerelatedtoawiderangeofbothdomestic
andinternationalfactors.
Hence, while it is expected that the economy will
follow a cycle of expansion and contraction,itisverydifficulttoforecastthesizeof
eachmovementandtheturning pointsofthecycle.
InwhatsensecouldanADIhaveanoptimallevelofliquidity?
AnADIshouldaimforanoptimallevelofliquidity.This positionoccurswhenthemarginal benefitofreducedliquidityriskfromanextradollarofliquidityisequaltothemarginalcostofthatadditionaldollarofliquidityduetothereducedinterestrevenue.Abankwouldhavetoo muchliquidityifithadinexcessofthisoptimumandtoolittleliquidityifithaslessthanthis optimum.
Whatarecontingentliquidityneeds?Whyisitparticularlydifficulttoprovideforthisform ofliquidity?
Contingentliquidityneedsareduetounusualeventsthataredifficulttopredict.Forexample,if anotherbankbecomesinsolventthismaytriggerarunonyourbank. Itisdifficulttoplanforthistypeofliquidityfirstly,becauseofthedifficultyofpredictingthe timingoftheseeventsandsecondly,becausetheliquidityrequirementislikelytobeextremely largeeventhoughitmayonlybeforarelativelyshortperiod.
